Thank You

Error.

Since this column began its current run on July 9, small-cap stocks have slightly lagged behind shares of larger companies. The Russell 2000, a popular small-capitalization benchmark, has returned 3.4%, versus 3.7% for the Standard & Poor's 500.

Fortunately, Sizing Up Small-Caps doesn't concern itself with "the market" but with fundamentals of individual businesses, to determine whether there might be value present in a company's current stock price. The 20 small-caps we "sized up" in this year's second half handily outperformed the market, returning 15.3% through Dec. 27, dividends included, versus a price return of 2.3% in the same span for the Russell 2000.

As Warren Buffett once said, "Price is what you pay, and value is what you get." Mindful of that, we have focused on companies whose shares have fallen out of favor, but where a lurking catalyst, be it a potential restructuring, spinoff, asset sale, return of capital, or cyclical improvement could allow value to surface. Small-caps afford many such opportunities, as they are often underfollowed by Wall Street analysts and ignored by investors.

Farmer Brothersfarm -3.6964980544747084%Farmer Bros. Co.U.S.: NasdaqUSD24.75
-0.95-3.6964980544747084%
/Date(1427835600113-0500)/
Volume (Delayed 15m)
:
39518AFTER HOURSUSD25.7146
0.9646000000000013.897373737373737%
Volume (Delayed 15m)
:
3871
P/E Ratio
35.869565217391305Market Cap
426414388.345336
Dividend Yield
N/ARev. per Employee
291691More quote details and news »farminYour ValueYour ChangeShort position
(ticker: FARM), a coffee producer and distributor, has been the column's biggest winner to date, returning 99% through Friday's close of $14.46. The shares were recommended on July 30. At that time, they had fallen by more than 50% in the two previous years, as the price soared for green Arabica coffee beans, the company's largest commodity cost, sending Farmer's gross profit margins slumping. But a reversal was brewing; the price of green coffee had fallen by nearly half from its 2011 peak, and we figured the decline soon would show up in margins.

That is exactly what happened. In the September quarter, gross margins expanded to 37.4% from 32.7% a year earlier. Other things have gone right for the company, as well. Farmer's customer base, which had been declining since 2009 owing to recession-related restaurant closures, is now expanding, and the company has added new accounts, including
McDonald'sMCD -0.4495300367797303%McDonald's Corp.U.S.: NYSEUSD97.44
-0.44-0.4495300367797303%
/Date(1427835631465-0500)/
Volume (Delayed 15m)
:
5437495AFTER HOURSUSD97.44
%
Volume (Delayed 15m)
:
119495
P/E Ratio
20.090721649484536Market Cap
94074326896.3406
Dividend Yield
3.4893267651888342% Rev. per Employee
65336.4More quote details and news »MCDinYour ValueYour ChangeShort position
(MCD). At the same time, productivity improvements have lowered costs.

Anton Brenner, who covers Farmer Brothers for Roth Capital Partners, estimates that the company could earn 65 cents a share in the current fiscal year, ending in June, marking its first profitable year in four. In fiscal 2014, Brenner thinks Farmer could earn 85 cents a share.

We still like Farmer's long-term prospects, but with the shares trading at 17 times next year's estimates, further appreciation may be limited. We recommend taking profits.

The strategy already had gained some traction by the time our story went to press, and stood a good chance of working. Big 5 shares have rallied 37% since, to a recent $12.57, as the plan has unfolded with success.

In the September quarter, Big 5 enjoyed its best same-store-sales growth since 2006. Sales at stores open at least a year rose 5.2% for the period, compared with a 2.9% drop in the March quarter. Profit margins, too, have staged a recovery. Analysts expect Big 5 to earn 70 cents a share this year, well above the 53 cents the company earned in 2011. In 2013, earnings could increase to 87 cents a share.

We see more upside ahead.

Sean Naughton, who covers Big 5 for Piper Jaffray, notes that operating margins are still well below the 2007 peak. For the full year, he sees operating margins of 2.7%, compared with 8.2% in 2004. If the retailer can regain even half of its lost margin, Naughton believes earnings could increase to $1.50 a share in the next few years.

NOT MUCH HAS HAPPENED SINCE we wrote about real-estate and cinema operator
Reading International's
RDI -1.2481644640234948%Reading International Inc.U.S.: NasdaqUSD13.45
-0.17-1.2481644640234948%
/Date(1427835600127-0500)/
Volume (Delayed 15m)
:
252273AFTER HOURSUSD13.3089
-0.1411-1.0490706319702603%
Volume (Delayed 15m)
:
128905
P/E Ratio
12.227272727272727Market Cap
315190526.527367
Dividend Yield
N/ARev. per Employee
106813More quote details and news »RDIinYour ValueYour ChangeShort position
(RDI) potential to unlock value. In an Aug. 13 story, we made the case that the shares could more than double if Reading were to sell or remodel its two New York City properties, Cinemas 1, 2 & 3 on Third Avenue, and the Union Square theater, both of them worth significantly more than their stated book value.

The company hasn't reported any activity around those properties. But management has shown it is capable of monetizing its real estate. On Nov. 29 the company announced it had sold an office building in Brisbane, Australia, for $12.2 million. The shares have gained 5.4% since. They are up 18.4%, to $6, since we first wrote about the stock. Reading's shares are still a good bet for patient investors.

A difficult defense-spending environment and worries over the fiscal cliff have hampered shares of the defense contractor. But the stock, which finished Friday at $4.80, largely reflects those concerns.

Kratos boasts a strong portfolio of defense-electronics products, such as those used in unmanned surveillance planes and ballistic-missile-testing systems, areas that the Department of Defense isn't likely to cut. In the September quarter, despite the negative backdrop, Kratos enjoyed a 10% rise in organic sales from the prior period.

Free cash flow remains robust, with Michael Ciarmoli, of Key Bank Capital Markets, expecting $41 million in 2012 and $73 million in 2013. That cash will likely be used to pay down debt. Our target price of $11 a share still stands.